What Specific Failures in Counterparty Due Diligence Contributed to the Archegos Losses?

Concept

The Archegos Capital Management collapse was a systemic event rooted in the fundamental architecture of counterparty risk assessment. The core failure resided in the inability of global prime brokers to perceive the aggregate risk of a single counterparty operating through a network of opaque financial instruments. Each institution viewed its exposure to Archegos in isolation, a perspective that was technically accurate within its own silo but systemically blind.

The very instruments used, primarily total return swaps (TRS), were designed to provide leverage while obscuring the ultimate beneficial owner’s total position from the broader market. This created a critical information asymmetry where Archegos maintained a complete picture of its portfolio, while its counterparties each held only a single, misleading piece.

This was a breakdown in the conceptual understanding of modern counterparty risk. The due diligence process at several major banks operated on a model that was sufficient for a simpler, less interconnected market. It failed to account for a highly sophisticated family office deliberately structuring its activities to exploit the seams between institutional risk management systems. The banks’ frameworks were designed to measure the risk of the visible portion of the iceberg ▴ the collateral and the specific swaps on their own books.

The fatal flaw was the failure to design a system capable of estimating the size and shape of the submerged, invisible mass of risk distributed across multiple counterparties. The losses were a direct consequence of this conceptual gap. The systems in place were asking the wrong question. They asked, “What is our specific risk to Archegos?” The question they needed to answer was, “What is Archegos’s total risk to the system, and how much of that is concentrated in the same set of securities we are financing?”

The collapse revealed that a counterparty’s total systemic footprint, not just a bank’s individual exposure, is the critical unit of analysis for effective due diligence.

The situation was exacerbated by Archegos’s status as a “family office,” which exempted it from certain regulatory disclosures required of other large market participants like hedge funds. This regulatory classification, combined with the use of swaps, created a perfect storm of opacity. The due diligence failure was therefore twofold. It was a failure of imagination on the part of the banks, which did not adequately conceive of a counterparty accumulating such a massive, concentrated position across the street.

Secondly, it was a failure of process, where existing risk models and due diligence checklists were not equipped to detect or act upon the subtle signs of this systemic concentration. The prime brokers were, in essence, competing with each other to lend to the same hidden, hyper-leveraged strategy, a competition that blinded them to their collective peril.

Strategy

The strategic failures in counterparty due diligence that led to the Archegos losses were multifaceted, stemming from a misalignment of commercial incentives, flawed risk governance structures, and a passive approach to information gathering. The prime brokerage business model, driven by intense competition for a limited pool of high-volume clients, created a strategic imperative to prioritize revenue generation over rigorous risk discipline. This manifested as a willingness to extend vast amounts of leverage with insufficient margin, effectively enabling the risk-taking behavior of clients like Archegos. The strategy was one of client acquisition and retention at the expense of a holistic risk assessment.

The Flaw of the Siloed View

A central strategic error was the vertically-siloed approach to risk management. Each prime broker’s due diligence and ongoing monitoring focused almost exclusively on its bilateral relationship with Archegos. The risk models were calibrated to the collateral and swap positions held at that specific bank.

This approach failed to incorporate a strategic analysis of the counterparty’s broader market activities. A more robust strategy would have involved actively seeking information to model the counterparty’s potential aggregate positions.

This could involve:

• Scenario Analysis Based on Market-Wide Data ▴ Analyzing market volume and price action in the handful of stocks Archegos was known to favor (like ViacomCBS, Discovery, Tencent Music) to estimate the potential size of a single actor’s influence. A strategic due diligence framework would have tasked analysts with asking, “Who is driving the unusual activity in these specific names, and what if it’s one of our own clients operating at scale?”
• Qualitative Due Diligence ▴ Conducting deeper, more intrusive due diligence on the counterparty’s strategy. Instead of simply accepting Archegos’s status as a family office, a more strategic approach would involve understanding their investment philosophy, their concentration limits, and their use of leverage across all providers. The fact that Bill Hwang had a history of regulatory sanctions should have triggered a strategic review of his trading style, which was known to involve high concentration and leverage.

How Could Risk Governance Have Been Better Structured?

The governance framework at institutions like Credit Suisse proved to be strategically deficient. The existence of a risk committee is standard; its effectiveness is what matters. The Counterparty Oversight Committee (CPOC) at Credit Suisse identified the risks associated with Archegos but failed in its strategic execution by not assigning clear actions, deadlines, or accountability. This points to a culture where risk management is a reporting function rather than an empowered governing force.

A focus on short-term revenue generation strategically overshadowed the clear warnings produced by the banks’ own risk identification systems.

A superior strategic framework for risk governance would possess the following characteristics:

1. Empowerment of the Second Line of Defense ▴ Risk managers must be empowered to enforce limits and demand additional margin, even against the objections of the front-office relationship managers. Their compensation and performance should be tied to the long-term health of the risk portfolio, not short-term revenue targets. At Credit Suisse, risk managers intended to ask for more margin but were overruled by business-side managers.
2. Dynamic and Holistic Margin Models ▴ The margining strategy itself was a failure. Static or slow-to-adapt margin requirements were insufficient for a portfolio as volatile and concentrated as Archegos’s. A strategic approach uses dynamic margining that accounts not just for market volatility (VaR), but also for portfolio concentration (liquidity risk) and the counterparty’s overall leverage (wrong-way risk).
3. Mandatory Escalation and C-Suite Visibility ▴ Persistent limit breaches should trigger automatic escalation protocols that bring the issue to the attention of senior management. The fact that the CEO and CRO of Credit Suisse were reportedly unaware of the Archegos exposure until the final days before its collapse is a catastrophic failure of strategic governance.

Comparative Risk Postures of Prime Brokers

The divergent outcomes among the various prime brokers exposed to Archegos reveal the difference between a strategic and a passive risk posture. Some firms, like Goldman Sachs and Morgan Stanley, were able to exit their positions quickly and with minimal losses. This suggests their strategic framework for due diligence and risk monitoring was more effective. They likely had more robust systems for real-time risk visualization and a culture that enabled decisive action when red flags appeared.

The table below provides a simplified comparison of the strategic postures:

Ultimately, the Archegos saga demonstrates that counterparty due diligence cannot be a static, check-the-box exercise. It must be a dynamic, strategic function that actively seeks to understand the counterparty’s holistic market presence and is empowered by a governance structure that prioritizes long-term stability over immediate profit.

Execution

The execution of counterparty due diligence in the case of Archegos was a catastrophic failure at multiple levels of operational procedure. The breakdown occurred not because the necessary risk management tools were unavailable, but because they were ignored, overridden, or poorly implemented. A granular analysis of the execution failures provides a clear playbook for what not to do, and a framework for constructing a more resilient operational protocol for counterparty risk management.

The Operational Playbook for Failure

The sequence of events leading to the multi-billion dollar losses at several prime brokers followed a distinct operational pattern of failure. This pattern can be deconstructed into a series of procedural missteps:

1. Flawed Initial Onboarding ▴ The due diligence process began with a critical error ▴ failing to properly weight the significance of founder Bill Hwang’s regulatory history. A 2012 settlement with the SEC for insider trading and a subsequent trading ban in Hong Kong were known facts. Operationally, this should have resulted in, at a minimum, a higher risk rating for Archegos, stricter concentration limits, and elevated margin requirements from day one. Instead, these red flags were dismissed.
2. Ignoring System-Generated Alerts ▴ The risk management systems at firms like Credit Suisse were, in fact, functioning on a technical level. They correctly identified “large, persistent limit breaches” as Archegos’s portfolio grew in size and concentration. The operational failure was the human override. Business-line managers and even in-business risk personnel systematically ignored these alerts, creating a culture where red lights were treated as mere suggestions.
3. Failure to Enforce Margin Calls ▴ As the value of Archegos’s concentrated positions began to decline, margin calls were made. However, the execution of these calls was flawed. Instead of demanding immediate and full satisfaction, some banks reportedly allowed Archegos time to meet the calls or negotiated the amounts, giving the fund more rope. A strict operational protocol requires that margin calls be met promptly and in full, with failure to do so triggering immediate de-risking procedures.
4. Lack of a Coordinated Deleveraging Strategy ▴ When the collapse became imminent, the prime brokers did not act in a coordinated fashion. They engaged in a frantic and disorderly liquidation of the collateral, which in turn accelerated the price decline of the underlying stocks and magnified the losses for everyone involved. While a fully coordinated response may have raised anti-trust concerns, the complete lack of communication between the lenders during the final hours was a failure of execution.

Quantitative Modeling and Data Analysis

A primary execution failure was the inadequacy of the risk models used. Many firms relied heavily on Value-at-Risk (VaR) models that were ill-suited for Archegos’s specific risk profile. VaR models are often based on historical volatility and assume a degree of portfolio diversification and market liquidity that was absent in the Archegos portfolio. The fund’s positions were highly concentrated in a small number of illiquid stocks, a fact that standard VaR models would not adequately capture.

A more robust quantitative execution would have involved extensive stress testing and scenario analysis specifically designed to model the risk of a concentrated, leveraged portfolio. The table below illustrates the estimated losses incurred by the major prime brokers, a direct result of these execution failures.

Predictive Scenario Analysis a Hypothetical Case Study

Let us construct a hypothetical scenario to illustrate how a robust execution of due diligence could have averted the disaster. Imagine a fictional prime broker, “Titan Bank,” is considering taking on Archegos as a client in 2018. The head of counterparty risk, Dr. Anya Sharma, initiates a deep due diligence process.

First, the onboarding team flags Bill Hwang’s 2012 SEC settlement. Instead of dismissing it, Dr. Sharma’s protocol requires a “qualitative risk overlay.” Her team interviews former colleagues of Hwang and builds a psychological and strategic profile, concluding he has a high propensity for concentrated, leveraged bets. This results in an internal “Concentration Risk” score of 9 out of 10 for Archegos.

Next, Titan Bank’s quantitative team runs a stress test based on this profile. They model a portfolio concentrated in just five volatile tech stocks, with leverage at 5:1, financed via swaps. They simulate a “liquidity crisis” scenario where the price of the largest holding drops 30% and the bid-ask spread widens by 500%.

Their model, which goes beyond standard VaR, predicts that a standard margin of 15% would be wiped out instantly and that liquidating the collateral would cause a further 20% price drop, leading to catastrophic losses. The model calculates a required “Concentration and Liquidity Premium” margin of 40% for this specific client and strategy.

The decisive failure was one of execution; the risk was identifiable and the tools to mitigate it existed but were not properly deployed.

When the business-side managers propose a standard 15% margin to win the Archegos account, Dr. Sharma’s team presents their findings. The Counterparty Oversight Committee, empowered by the bank’s charter, has the authority to veto the relationship or enforce the 40% margin requirement. The business managers argue that Archegos will simply go to another bank. Dr. Sharma’s response is that the bank’s role is to price risk correctly, not to win every client at any cost.

The committee sides with the risk assessment. Archegos rejects the 40% margin and takes its business elsewhere. Titan Bank forgoes a few million in annual fees. In March 2021, as other banks are writing down billions in losses, Titan Bank’s risk committee reviews the Archegos decision as a successful execution of their due diligence protocol.

This case study, while hypothetical, demonstrates that the Archegos collapse was a failure of execution. The data was available, the risks were foreseeable, and the tools for proper modeling existed. The breakdown was in the operational discipline to use them correctly and the governance structure to enforce the results.

Reflection

What Is the True Cost of a Mispriced Relationship?

The Archegos event compels a re-evaluation of how financial institutions perceive and price counterparty relationships. The operational protocols and risk models are merely tools. The ultimate decision-making process rests on a cultural foundation.

When a firm’s culture values short-term revenue above all else, it will inevitably find itself mispricing risk, often with catastrophic consequences. The billions lost by Credit Suisse and others were the final, lagging invoice for a service that was underpriced for years.

Reflecting on this incident requires moving beyond a simple forensic analysis of broken rules and flawed models. It necessitates a deeper introspection into the incentive structures that drive behavior within large financial organizations. How does your own operational framework balance the competing pressures of revenue generation and risk management?

At what point does the pursuit of a single, lucrative client relationship begin to introduce systemic fragility into your own portfolio? The Archegos collapse serves as a stark reminder that the most significant risks are often not hidden in complex derivatives, but in plain sight, embedded in the cultural and strategic choices a firm makes every day.